Waiting for the flood

Date: Tuesday, February 19, 2008
Author: Christine Williamson, PIonline.com

At least $52 billion in unallocated hedge fund cash sitting on launching pad, looking for a green light.

Institutional investors allocated a record $66 billion to hedge funds in 2007, but $52 billion of that has yet to be invested.

The amount awaiting investment suggests an avalanche of new money will be coming to hedge funds soon. And the $52 billion is a low-ball estimate because allocation amounts routinely aren’t given when searches are made public. Plus, a number of searches never are publicly known.

Meanwhile, $1.5 billion of new searches were reported in the first six weeks of 2008, while $2.2 billion was awarded to hedge funds.

“I think everyone is holding back, holding their breath about hedge fund investments. But when it happens, it will be very big,” said Robert Discolo, managing director and head of the hedge fund strategies group at AIG Investments, New York. AIG manages $9 billion in hedge funds of funds, about half of which is from the general account of the firm’s insurer parent.

The reported activity by institutional investors in 2007 was a 165% increase from the $24.7 billion institutional investors earmarked for hedge funds in 2006 and far and away the largest in the four years that Pensions & Investments has tracked the investments.

But as markets got rockier after last summer, searches and hires slowed dramatically, part of the reason for the big buildup in hedge fund allocations awaiting investment.

Hedge fund search and hire activity tracked by P&I dropped 39% to $8.7 billion in the fourth quarter from $14.2 billion in the third quarter and $25 billion in the first quarter of 2007.

The hiccup in hedge fund flows is nothing to worry about, according to strategy consultants at Casey Quirk & Associates LLC, Darien, Conn.

No straight line

“We remain convinced that institutional investment in hedge funds soon will top $1 trillion, but we’re also convinced that the industry won’t follow a straight line in getting to that point,” said John Casey, the firm’s chairman. “There’s a secular — not a cyclical — move toward alternatives, including hedge funds. Pension fund executives are committed for so many reasons to moving into alternatives, but it just won’t be a tidy process.”

Mr. Casey said some pension fund trustees likely are choosing “to sit on the sidelines during this rather ugly period” and may stay there for a quarter or two afterward.

“Trustees and staff that have a plan for implementing their hedge fund investments, that aren’t looking for home runs, but rather, for volatility control and diversity” don’t have to hurry to invest, he added.

Institutional investors were exceptionally slow in making hiring decisions in 2007, which contributed to the “big overhang we’re all just waiting to see invested,” said the chief executive officer of a midsize hedge fund of funds, who asked not to be identified. For example, staff at one institution that was “ready to invest last spring when we presented in a final, still hasn’t pulled the trigger. They keep reassuring us that the search is active, that they will make a decision, but it’s been almost a year,” said the source.

Another practice that’s picked up steam in the last six months is that of pacing allocations over time, rather than investing them in one lump. “A lot of institutions are choosing to dollar-cost average and spread out their investments because they are really nervous about the market,” said the fund-of-funds source.

That said, “there’s been a real pickup in activity in the last month. Just an enormous resurgence of new or renewed search activity. Our pipeline is completely full and we are incredibly busy this month and next,” the source said.

Some hires proceed

Indeed, a number of institutional investors have moved ahead with hedge fund hires, including:

•the $12 billion School Employees Retirement System of Ohio, Columbus, in January invested $250 million each in six multistrategy hedge funds;

•the $84 billion Ohio Public Employees’ Retirement System, Columbus, in December invested $50 million each in eight multistrategy hedge funds;

•the $164 billion New York State Common Retirement Fund, Albany, invested $385 million in nine hedge funds and funds of funds during the fourth quarter and so far this year.

Other institutions remain committed to implementing their hedge fund investment programs in 2008.

The $10.5 billion West Virginia Investment Management Board, Charleston, for example, has allocated 10% of plan assets to hedge funds, and staff members now are working on an implementation plan, said Craig Slaughter, executive director.

Mr. Slaughter said one decision has been made — to invest directly in hedge funds, rather than hedge fund of funds — but it’s not clear yet whether all of the $1 billion allocation will be invested this year or over a longer time period. The board received legislative authorization to invest in hedge funds last year.

Officials of the $81 billion New Jersey State Investment Board, Trenton, are seeking to make $1.7 billion of direct hedge fund investments and to invest $250 million in hedge funds of funds before June.

Also, officials at the $54 billion Massachusetts Pension Reserves Investment Management board, Boston, announced earlier this month a $540 million search for a hedge fund-of-funds manager.

New Mexico backlash

Regardless of their own willingness to invest in hedge funds, some public pension plan officials are facing political interference. The reputation of hedge funds as “risky investments” or as contributing to current credit and subprime market is not going unnoticed by politicians.

The most recent attempt to restrict investments was quashed — at least temporarily — just last week, in New Mexico where state Rep. Teresa A. Zanetti sponsored a bill that would ban future hedge fund investments by the $15 billion New Mexico State Investment Council, Santa Fe. As of Dec. 31, the council had a $1.48 billion absolute-return portfolio, and in November, it increased its hedge fund target allocation to 15% from 10% of total assets. Ms. Zanetti’s bill would not have affected New Mexico’s other public pension plans, including the $15 billion Public Employees Retirement Association and $9.6 billion Educational Retirement Board, both in Santa Fe.

The council began investing in hedge funds and other alternative investments in 2005 when the Legislature removed the so-called legal list that limited the funds’ investments. Investment council officials argued that Ms. Zanetti’s bill defined hedge funds so broadly it could have included private equity and real estate investments, said Charles Wollmann, council spokesman.

Ms. Zanetti postponed her bill for this year, but said in an interview that a joint committee of the state House and Senate will look into all three plans’ hedge fund exposure, valuation methods, liquidity and the amount of leverage used. She plans to reintroduce a new hedge fund bill that covers all three plans next year. Ms. Zanetti added she also might look at the three funds’ private equity investments because, like hedge funds, those investments are not regulated, not transparent and are riskier than traditional asset classes, she said.

“Hedge funds don’t hedge any longer,” and are too risky for the three state funds, Ms. Zanetti said.

Arleen Jacobius contributed to this story.